The Mystery of Banking

April 20th, 2010

The Mystery of Banking is not just another book on banking. It pulls back the curtains that hide the flaws of fractional-reserve banking and explains the differences between loan banks and deposits banks. Further, it discusses why free banking would provide a much more stable banking system without the inflation that is inherent in any system that utilizes a central bank. The Mystery of Banking also discloses how loan banks and deposit banks were married because of poor legal decisions.

Although many books discuss fractional-reserve banking, Murray Rothbard, with simple T-charts, explains the simplicity of fractional-reserve banking and discloses why it inflates the money supply. Although this book mentions the immorality of fractional-reserve banking, that is not the focus. The Mystery of Banking deals more with the mechanics of fractional-reserve banking and its inflationary impact.

Many critics of our monetary system lay the blame for inflation solely at the feet of the Federal Reserve System, through its purchases of debt instruments with money created out of thin air. However, the greatest creation of money out of thin air comes on the books of the banks when they make loans.

While the Fed itself is not the biggest inflator, the very existence of the Fed, the central bank of the United States, encourages banks to collectively be the primary cause of the inflation of the money supply. Rothbard includes eight chapters on central banking because banking in today’s world cannot be discussed without a thorough understanding of the concept of central banking.

Much has been written about the Fed, central banking and their flaws. Still, the chapters on central banking are worth reviewing for clarification. However, discussions of loan banks and deposit banks are not easily found, and most readers will find Rothbard’s explanations enlightening.

Loan banks started out doing just what the name implies: they loaned money. Investors put their money in loan banks expecting to earn profits on the money loaned. When money is loaned, interest (or profits) is earned for doing without the money for a period of time and for taking risks (The loaned money may not be paid back.) Deposit banks, however, began as totally different institutions from loan banks.

Originally, deposit banks offered bailment services. They would accept items such as gold and silver and issue receipts. On presentation of the receipts, the items were returned to the depositors. Deposit banks earned profits by charging for their bailment services; loan banks earned profits by charging interest on the money loaned.

In a series of English court decisions, the line between loan banks and deposit banks was not blurred but erased. Those decisions resulted in the evolution of monetary system that today permits banks to be the great inflators that they are. (Rothbard does not discuss it, but old court decisions in England hold precedence in American law.)

Rothbard does not leave readers hanging with the notion that inflation is a necessary evil that must come with banking. He offers an explanation of free banking, which, unfortunately, has never been tried in modern times.

Under free banking, banks can inflate if they want but if their depositors get wind of it and want their deposits returned, the banks do not have central banks or governments to bail them out. Under free banking, the government could not suspend the redemption of paper receipts for specie (gold and silver coins). In short, the marketplace monitors the soundness of the individual banks. The banks must earn the respect of the populace. The populace, in return, has no government or central bank “guarantee” that their deposits will be safe. Free banking requires diligence by depositors.

In today’s financial world, this may seem a reckless notion, that the marketplace can monitor the banks. But, it is not. If the banks did not have the assurances (written, tacit or otherwise) that the governments would bail them out, would they not be more careful with their lending policies? And, would depositors not ask a few questions before depositing with just any bank?

We do not expect the government to guarantee our car insurance or life insurance companies, but we expect the government to guarantee our bank deposits. This notion comes from 1930s legislation (many times modified) that was supposed to offer stability to our financial system. The concept, of course, is flawed, as now we see that the government’s “guarantee” is only money created out of thin air. It was the Fed’s reckless policies of the 1920s (The Roaring Twenties) that brought on the Great Depression. (See Rothbard’s magnum opusAmerica’s Great Depression for a thorough discussion of this heretical view.)

Advocates of free banking assert that it has only been tried once: in Scotland, 1727 to 1845. Rothbard includes an appendix, The Myth of Free Banking in Scotland, which reveals that Scotland during that time had a highly developed monetary, credit, and banking system. Further, there was no governmental monetary policy, no central bank, and virtually no political regulation of the banking industry. During those nearly one hundred twenty years, Scotland enjoyed remarkable macroeconomic stability.

But, free banking, in its pure form was not practiced in Scotland 1727 to 1845. Several times, when the banks issued too much paper, the government permitted them to suspend redemption in specie (coin money). As long as the government stands ready to abrogate the redemption right of receipt holders, free banking is not practiced. Still, Scotland enjoyed great prosperity and with a stable monetary system while many of the features of free banking were practiced.

The Mystery of Banking is an excellent read for gold and silver investors. It will add further to their understanding of banking and inflation, which will enable them to better understand their investments in precious metals.

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